Have S&P 500 Index Funds Lost their Sparkle?

In 1976, the Standard and Poor's 500 became the first stock market index tracked by a fund when Vanguard launched its legendary Vanguard 500 Index Fund (VFINX), which started with just $11 million and grew to become the largest U.S. equity mutual fund in existence by the late 1990s.

The year 1992 saw the first successful launch of an exchange-traded fund (ETF). It, too, tracked the S&P 500. Nearly a quarter century later, and largest ETF in existence is SPY, which tracks — you guessed it — the S&P 500.

The Granddaddy of all Indexes Rules the Index ETF World

According to Forbes, the S&P 500 holds direct index assets of nearly $2 trillion, with an astounding $5 trillion benchmarked to the index, including derivatives. The S&P is the most important and most watched index in the world. The 500 mostly-U.S. companies it tracks are the most liquid in the world, and the index is the central indicator of the health and temperament of the overall stock market.

As index ETFs soared in popularity because of their low cost, simplicity and diversification, the funds that track the S&P 500 naturally rose to the top of the index fund world.

However, for many index fund investors, the honeymoon period may be ending.

The S&P 500 Misses Much of the U.S. Market

As Forbes recently pointed out, the 500 companies tracked by the S&P 500 represent around 80 percent of all market capitalization in the United States, which, on the surface, makes it a logical vehicle for investors looking to capture a wide swath of the U.S. market. However, the reality is, the S&P 500 tracks just a fraction of the nearly 4,000 U.S. stocks that are traded on the market.

Index funds that track the S&P miss literally thousands of mid-cap, small-cap and micro-cap stocks. Funds like the Vanguard Total Stock Market Index (VTSMX), which capture more than 99 percent of the market, have filled that void — and these comprehensive index ETFs are luring more and more investors away from traditional S&P 500 funds.

The S&P 500 is Still Good, but no Longer Unbeatable

MarketWatch points out that in the year 2000, when index ETFs began gaining widespread, mainstream popularity, the S&P was not just the most famous index, but it also displayed the performance to back up its popularity with index investors. In the two decades leading up to the turn of the millennium, the S&P 500 had compounded at 18 percent. During the last five years of the 1990s, it compounded at a staggering 28.6 percent.

However, that was then.

In the ensuing 15 years, the S&P 500 has been good — but not good, enough to justify its continuing position as the go-to index ETF for domestic stocks. Many investors who have purchased nothing but S&P index funds are now dusting off their budget planner worksheets to see if they could have done better with other domestic ETFs. It turns out, they probably could have.

After all, eight of the 10 Vanguard funds that MarketWatch profiled beat the Vanguard S&P 500 index fund over the last 15 years.

The S&P remains the most important stock market index in the world, and the funds that track it are safe, profitable, and as popular as ever. However, more and more index investors are falling out of love as other funds offer them everything in the S&P 500, plus the other 3,500 stocks in the lower 20 percent that the S&P misses.

Chancellor of the Exchequer of the United Kingdom from 1992 to 2007. Prime Minister of the UK between 2007 and 2010. Inaugural 'Distinguished Leader in Residence' at New York University. Advisor at World Economic Forum